Contributing editor Ryan Irvine is back with us this week with an analysis of the U.S. stock market and an update on one of his most successful recommendations. Ryan is the CEO of Keystone Financial (www.KeyStocks.com) and one of Canada's leading experts on small-cap securities. Here is his report.

Ryan Irvine writes:

With the S&P 500 up over 18% year-to-date and about 34% since the beginning of 2012, it is fair to ask if broader North American markets should be considered overvalued. Anecdotally, it is certainly more difficult to identify striking value than it has been over the past several years. But it's not impossible as growth has picked up in select areas.

We have seen this notably in Western Canadian infrastructure with companies like Macro Industries (TSX-V: MCR, OTC: MCESF). Macro is a recent addition to our research coverage - it was recommended in June and is up 65% since then. This is a company that operates in a true pocket of strength.

One of the most popular (but not necessarily best) ways of measuring a market's valuation is the price/earnings ratio.

While no one disagrees about what the "p" is when calculating the ratio, there is no consensus on how to define the "e" - earnings per share. One point of dispute is on whether to use analysts' earnings estimates for the coming year or reported company earnings from the previous 12 months (trailing earnings). For the record, we consider both as well as a number of other factors.

Consider the S&P 500's current p/e based on trailing earnings. For the four quarters through June 30, the index's earnings per share amounted to $91.16, according to S&P Dow Jones Indices. That translates into a p/e ratio of 19.31, which is higher than 79% of comparable readings since 1871, according to a database maintained by Yale University professor Robert Shiller. This paints a bearish near-term perspective.

Current S&P 500 PE Ratio: 19.31

Oct-13

Mean:

15.5

Median:

14.51

Min:

5.31

(Dec 1917)

Max:

123.79

(May 2009)

PE since 1871

Of course, bulls will point out that forward estimates for earnings call for strong growth in 2014. According to FactSet Data Systems, the consensus from Wall Street analysts is that earnings from companies in the S&P 500 will be $121.95 a share next year, which translates into a p/e ratio of 13.6. That is 6% less than the 14.5 median of historical p/e ratios in Prof. Shiller's database.

Bears will counter-punch with the widely acknowledged fact that Wall Street analysts, many from the sell side, are forever too optimistic. In addition, analysts' estimates focus on what's known as "operating earnings," a looser category than the actual reported earnings used to calculate the average of past p/e ratios. Thus, they are often adjusted higher.

This leaves us in a formidable tug-of-war in terms of broader market valuations.

If we take a look at the p/e on the S&P over the past 20-years, we get an average of 25.23 which paints the current p/e of 18.2-18.8 in a bullish light. However, one must remember that from a historical perspective, the last 20 years have boasted some of the highest multiples on record including the 2009 mark of 70.89 following the credit crisis and the tech bubble induced mark of 46.18 in 2002 which have skewed the multiple higher. Remove these two years and the average drops considerably to 21.53, but this still remains well above the historical mean of 15.5.

There are of course other methods based on earnings which we can employ to value the state of the broader market. One method which has proven successful in identifying market extremes (both over and undervalued) is the Shiller p/e ratio or cyclically adjusted price-to-earnings ratio, commonly known as CAPE. Developed by Robert Shiller and built off the work of legendary value investors Benjamin Graham and David Dodd, CAPE is a valuation measure usually applied to broad equity markets. It is defined as price divided by the average of 10 years of earnings, adjusted for inflation.

The central theme behind the CAPE is simple. Taking a multiple of one year's earnings is misleading because stock markets naturally adjust when investors believe profits are cyclically high or cyclically low. Compare prices instead to the average of earnings over 10 years (Prof. Shiller also corrects for inflation) and it becomes clearer whether stock markets are overvalued or undervalued.

For over a century, extremes in the CAPE have coincided with favourable times to buy and sell. By staying far above its long-term average during the 2003 to 2007 rebound that followed the Internet bust, the CAPE also provided a warning that the rally was not to be trusted - ahead of the far worse crisis of 2007-09.

Prof. Shiller and the CAPE are sounding the alarm once again, recently implying that the U.S. market is 62% overvalued and more expensive than any other big stock market.

Current Shiller PE Ratio: 24.22

Oct-13

Mean:

16.49

Median:

15.89

Min:

4.78

(Dec 1920)

Max:

44.2

(Dec 1999)

Shiller PE Since 1871

Economics without debate is like politics without scandal. It's not going to happen. It should be no surprise that the CAPE is under attack from another renowned economist, Jeremy Siegel, who contends that it is based on faulty data. Many on Wall Street discount CAPE, but most have a vested interest.

Prof. Siegel of the University of Pennsylvania's Wharton School has produced a new version of the CAPE, which he says corrects Prof. Shiller's mistakes. His version of the CAPE suggests that the U.S. stock market is sending a different signal - stocks are cheap.

Many investors, both short and long term, will contend that outside of the few days of the market crash in March 2009 when the CAPE fell briefly below its long-term average, Shiller's indicator has shown that U.S. stocks have been overvalued for over 20 years. Yet the benchmark S&P 500 has more than doubled since March 2009. It also doubled between 2003 and 2007. In total, the benchmark is up over 275% over the past 20 years.

Yes, the most recent "great recession" saw the largest drop in corporate profits on record. But consumer debt levels remain near record highs in the developed world and domestic growth is still muted at best. Supporters of CAPE will point out that casting doubt on metrics is a classic symptom of bubbles. Back in the tech bubble, analysts went from valuing companies based on price-to-earnings to price to-eyeballs or "Internet site impressions."

Quite frankly, we do not see anything close to this type of mania at present. Corporate balance sheets continue to strengthen and profits are trending in the right direction. Total U.S. household debt fell another $78 billion, or 0.7%, in the third quarter of this year. Since peaking in the third quarter of 2008, American households have reduced their debt burdens by $1.53 trillion, or 12%. Deleveraging is a positive story of the last few years. The shift is even more dramatic relative to the size of the overall economy; household debt totaled 85% of GDP in the third quarter of 2008 and was down to 67% in the second quarter of 2013.

But there is plenty of reason to worry broadly about the economy including public (unfunded pension liabilities included) and private (consumer) debt. While U.S. consumer debt has been headed in the right direction, levels still remain historically high. U.S. unemployment is also a big concern.

Within Canada, our relative insulation from the great recession has unfortunately spared us a valuable lesson and consumer debt has not been paid down. In fact, Canadians are borrowing more, piling on consumer debt - credit cards, conventional bank loans, car loans, and lines of credit. At some point this ends and a spending vacuum could limit growth.

Perhaps this partially justifies the S&P/TSX Composite's poor performance on a relative basis, being up a scant 2.6% this year and about 7% since the start of 2012. Slumping commodity prices are also a major contributor to the underperformance of the resource-laden TSX.

So where does this epic tug-o-war leave us? Which one of these statements is true: "The stock market is overvalued" or "The stock market is undervalued"? Every day you can find pundits with a strong opinion either way.

From our perspective, both statements are simplistic and most often irrelevant. It is a market of stocks, not a stock market.

We do not recommend you buy "the market," when you look to beat the market. Our clients create their Small-Cap Growth Stock Portfolios with discipline by purchasing 8-12 cash producing stocks over a 12-18 month period. Our holding periods are typically from one to five years and beyond.

Over that period, the broader market will have its ups, when it is likely overvalued based on a number of metrics, and downs, when it may show as undervalued based on those same metrics. What is important to us and to you is whether your 8-12 stocks are continuing to create shareholder value through a number of company-specific metrics including cash flow increases, growth, a higher return of capital (dividends), and an improving balance sheet.

Outside of this, Mr. Market will create a great deal of "noise" on a day-to-day basis. Try not to pay too much attention - it will allow you to sleep far better each night.

^ not so (anymore). Today's market is partially driven by asset allocation models and decisions hitting entire sectors as well as index funds, ETFs, closet indexing mutual funds and equity(index)derivatives/swaps. A buy or sell decision might be to buy a stock or a sector or a market.

Note: It would probably stretch the point to suggest any index derivatives influence is strong is since, despite trillions in notional value, these are mainly bookkeeping entries tied to the market, not directly into the market.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.